When this bubble bursts, there will probably be no fourth or fifth bubble, there’ll only be rubble.
The US economy and its economic system operate under the implicit belief that the Federal Reserve controls the direction of the economy and finance. This belief isn’t in Fed influence, it’s in Fed control: the Fed can reverse a stock market decline on a dime, it could possibly reverse a recession, it could possibly do “whatever it takes” to maintain markets stable and expansive.
The history of the past 30 years seems to support this belief. Each time a financial crisis has manifested, the Fed has “saved the day” with some recent policy extreme, changing the principles, jacking up its balance sheet 10-fold, and so forth.
The flaw on this confidence in Fed control is the three speculative bubbles which have inflated and burst within the era of Fed Control, 1995 to the current. These bubbles couldn’t have inflated and not using a “dovish” Fed pushing rates of interest down and juicing the economic system with liquidity / credit. Since all speculative bubbles eventually burst, the Fed is forced into “rescue mode” which requires ever more extreme manipulation, oops, I mean intervention, to stabilize the bubble bursting and inflate the subsequent bubble.
What few entertain as a possibility is the Fed is losing control of the economy and finance for systemic reasons that don’t have anything to do with Fed Policy per se. In other words, it’s not a “Fed policy error” that brings the system down, it’s much larger forces: diminishing returns and second order effects.
The immediate effect of latest Fed policy extremes is powerful, very like a brand new drug has a direct effect. But because the drug is injected repeatedly, it loses its efficacy. In medicine it is a biological process; in finance, it’s a psychological process as participants habituate to each recent Fed policy extreme and count on its 1) permanence and a couple of) continued efficacy.
For instance, the Fed’s trick of lowering bond yields / rates of interest. Participants can confidently increase their exposure to risk to insane levels and dispense with hedges because they’re confident the Fed will drop rates of interest back to zero if the stock market falters.
This confidence within the efficacy of Fed policies may be understood as a buffer, providing resilience and a backstop (“the Fed Put”) to any financial / economic instability. Participants stop panicking the moment the Fed broadcasts a brand new dovish policy, even when the policy has limited effect on real-world conditions. The decline of real-world efficacy is masked by the fast euphoria of participants, who’ve come to count on the Fed’a actions resolving crises literally overnight.
The decay of diminishing returns occurs under the radar. Few understand all of the Fed’s actions (reverse repos, etc.) or the dimensions of those operations, or their efficacy when it comes to correcting dis-equilibrium / instabilities within the real-world economy and markets.
While participants proceed to consider these buffers will at all times protect the system from hazard, the buffers have eroded. The subsequent Fed “save” fails, revealing the buffers have collapsed. Put one other way, the Fed has lost control.
Every recent Fed policy extreme generates second order effects which unleash unintended consequences. The prime example is moral hazard, the assumption that risk may be taken on to spice up speculative gains without suffering any consequences of that risk blowing up.
Since participants consider the Fed will slash rates of interest back to zero as soon as markets swoon, they increase their gambles based on that confidence. Any debt taken on today may be rolled over into lower rates in the longer term, so there’s no limit on risk or credit expansion. The riskiest possible expansions of credit–to fund stock buybacks, acquisitions of competitors, etc.–are greenlighted based on the boldness that the Fed will at all times push rates of interest back toward zero as soon as conditions wobble.
This confidence sets up a feedback loop by which Fed policies push participants to extremes of risk and debt that guarantee speculative bubbles inflate after which burst, demanding fresh Fed policy extremes. In other words, the Fed has created a doom-loop by which probably the most insane risk is transformed right into a “secure bet” based on the expectation of a Fed “save.”
But what if the Fed is unable to push policies to recent extremes resulting from systemic constraints? What if policies that worked like magic before now not work this time around resulting from diminishing returns / collapse of buffers?
What if the Fed cannot reverse the doom-loop of second order effects its previous policy extremes have generated? These outcomes don’t seem farfetched to anyone who studies systems dynamics. Slightly, they appear inevitable and predictable.
What if the Fed has already lost control but no one dares query the boldness in Fed omnipotence? It’s not the Fed policy extremes that work the magic, in any case; it’s the boldness of participants that resolves the bubble bursting crisis.
Those that have a look at systems dynamics have solid reasons for seeing this third massive All the things Bubble because the last bubble. When this bubble bursts, there will probably be no fourth or fifth bubble, there’ll only be rubble.
